View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Fcrr- release on delivery

1 -, QC a.m. E .D .T .
0;
October 25, 1989

Statement by
Manuel H. Johnson
Vice Chairman
Board of Governors of the Federal Reserve System
before the
Committee on Banking, Housing and Urban Affairs
United States Senate
October 25, 1989

SUMMARY OF TESTIMONY BY THE FEDERAL RESERVE BOARD
ON THE CONDITION OF THE BANKING SYSTEM

The last several years have been especially turbulent ones for
U.S. banks.

Although its problems have been far less than those

of thrifts, the banking industry is only now emerging from a
difficult period in which historically large numbers of banks
have failed.
An important theme when describing the recent
performance of the banking industry is that many institutions
have made progress toward increasing their profitability and
also their reserves and capital base.

The pace of improvement

has been slow, bank failure rates continue to be unacceptably
high, and clear pockets of real and potential problems remain.
Several large institutions, in particular, are reporting
third-quarter losses due to asset quality problems that, in some
cases, will give them losses for the year.

Nevertheless, the

industry seems to be better prepared to deal with its problems
now than it has been in several years.
The current condition of the industry reflects in
large part the length and nature of the current business cycle.
Although we are currently benefitting from the longest peacetime
expansion in U.S. history, it has not been felt equally by all
sectors of the economy.

In particular, the energy and

agricultural sectors, foreign loans, and real estate markets
have presented banks with substantial problems that, in varying
degrees, remain today.

2

Profitability.

Earnings of the U.S. banking industry rebounded

strongly during 1988 and have continued, for most institutions,
into 1989, as well.

Average return on assets during 1988 for

all insured commercial banks was 0.80 percent, the industry's
highest reported annual figure in years.

During the first half

of 1989, the industry reported an annualized average return on
assets of about 0.90 percent.

Until most recently, much of the

improvement since 1987 has reflected sharply lower loan loss
provisions by the largest institutions.

However, that situation

changed sharply in the third-quarter of this year, as some of
them made large loss provisions, mostly for real estate and
foreign loans.
Although these losses will temper the progress that
much of the industry has made, they have led to larger reserves
that should give these companies greater flexibility to deal
with their problems.

In some cases the losses have also been

coupled with plans to issue additional common stock.
Asset quality.

Asset quality remains the principal concern

facing the industry.

Loans to developing countries and real

estate loans, especially in New England and the Southwest,
remain of significant concern.

At more than $100 billion, the

industry's loans and commitments to highly leveraged borrowers
could also present problems for some companies, if not properly
managed.
Capital adequacy.

The industry's primary capital ratio has

increased from 7.9 percent at the end of 1987 to 8.25 percent at
mid-year 1989.

The general improvement has been widespread.

3

The preponderance of small- and medium-sized institutions now
meet the proposed 1992 risk-based standard, and most large
institutions also meet or are well on their way toward meeting
that future minimum standard.
Problem and failed institutions. Through September 1989, 160
commercial banks failed, with total assets of $25.7

billion.

The number and assets of problem institutions also remain
historically and unacceptably high, but appear to have peaked.
At the end of the third quarter, 1,166 commercial banks were
considered problem institutions, compared with a high of 1,575
banks at the end of 1987.

Most of them are located in the

Southwest, while conditions in the West and Midwest have
improved.
Conclusion.

Overall, much of the industry has made progress

during the past year and one-half to rebuild earnings and
capital and to compete effectively.

An important feature of

this effort has been the industry's trend toward consolidation,
brought about by mergers or acquisitions of failed institutions
and the existence of interstate compacts.

These mergers may

benefit individual institutions and could also lead to a
stronger and more competitive banking system.

It could also,

however, present some companies with new and expanded risks.
While the condition of the industry may have improved, we must
see further gains before we can say that the problems that have
beleaguered the industry are behind us.

*

*

*

*

*

*

*

*

*

*

*

*

*

I welcome the opportunity to be here today to present
the views of the Federal Reserve about the condition of the
nation's banking system.

During the last several years, the

U.S. financial system has had to operate in an environment
characterized by rapid change that has led to significant
pressures on many institutions.

The landmark legislation that

Congress recently enacted to deal with the savings and loan
industry is a visible illustration of the problems that certain
segments of our depository institutions industry have
encountered in recent times.

Although the problems of the U.S.

banking system have been far less than those of thrifts, the
banking industry is only now emerging from a difficult period in
which historically large numbers of banks have failed.

It is

important as we go forward that we remain vigilant in our
supervisory efforts to ensure that the banking system continues
to rebuild its strength and maintain the confidence of the
general public.
In my remarks today I will provide the Board's views
of the general strength and outlook for the U.S. banking
industry and of the principal issues that we face.

I will also

discuss some of the actions the Board has taken to foster a
sounder, more resilient, and competitive banking system.
process, I will generally address the areas cited in the

In the

2

Committee's invitation letter.

I would like to begin with an

overview of current banking conditions.

OVERVIEW

An important theme when describing the recent performance of the
banking industry is that many institutions have made progress
toward increasing their earnings and strengthening their
reserves and capital base.

The pace of improvement may be

slower than we would like, bank failure rates continue to be
unacceptably high, and clear pockets of real and potential
problems remain.

Moreover, some large institutions, in

particular, are reporting third-quarter losses due to asset
quality problems that will give many of them losses for the
year.

Nevertheless, the industry seems to be better prepared to

deal with its problems now than it has been in several years.
The progress— and the problems— that the industry has
seen reflect in large part the length and nature of the current
business cycle.

Although we are currently benefitting from the

longest peacetime expansion in U.S. history, it has not been
felt equally by all sectors of the economy.

The energy sector

has been hurt severely by lower oil prices; the agricultural
sector has been buffeted at times by low commodity prices and at
other times by poor crop yields; conditions abroad have
adversely affected the quality of many foreign loans and the
strength of export markets; and the volatility of interest and
exchange rates has increased the risks in many business sectors.
These events have also contributed to excess supplies of real

3

estate properties in some regions of the country that, at times,
have produced sharp declines in real estate values.

Those

declines have not only created severe problems for many thrifts,
but they have also affected some banks.
Technological change, financial innovations, and
increased competition have also altered the environment for at
least the major banking institutions.

Foreign institutions, for

example, have continued to increase their market share of U.S.
business loans.

Some of those foreign institutions have had

lower capital standards and broader powers, providing them with
a competitive edge.

Many of the larger U.S. banking

organizations have addressed this challenge, in part, by
expanding their so-called "off-balance sheet" activities, such
as interest rate swaps and financial guarantees, and by devoting
more energy to developing new financing techniques.

They have

also requested— and received— somewhat broader powers so that
they can continue to compete with both nonbank firms and foreign
banks.
The growing movement toward interstate banking has
further altered the competitive environment for U.S. banks.

The

number of mergers and acquisitions of major financial
institutions has increased sharply in recent years due to the
failure of some large institutions and to the adoption of
regional interstate compacts by many states.

In general, these

structural changes should help U.S. banks compete in world
markets by increasing their financial strength and operating
efficiencies.

It may also, however, present them with

4

additional challenges to implement the organizational and
operating changes they need in order to manage their risks
effectively.

As banking regulators, we need to monitor these

developments carefully in the months and years ahead as the
industry continues to revise its structure and as we resolve the
insolvent S&Ls.

RECENT FINANCIAL PERFORMANCE

Let me now turn to more specific indicators of recent banking
industry performance.

In general, these measures have shown an

improvement in recent periods, especially for the regional
institutions which are less exposed to heavily indebted foreign
countries.
Profitability.

Earnings of the U.S. banking industry rebounded

strongly during 1988.

Average return on assets during 1988 for

all insured commercial banks was 0.80 percent, compared with
0.11 percent in 1987.

This recent performance represented the

highest reported profitability measure for the industry in
decades.

Importantly, the strongest performance was reported by

many of the largest banks, which were responsible for the
industry's losses in 1987 and which have the greatest need to
strengthen their capital positions.

The 25 largest bank holding

companies, for example, reported a return on assets for 1988 of
0.90 percent, mostly reflecting the earnings of their subsidiary
banks.

Their 1988 results, however, reflected loan loss

provisions that, as a percent of assets, were significantly
lower than they had been in recent years.

5

For many institutions, last year’s relatively strong
earnings performance has continued into 1989, as well.

During

the first half of the year, both the largest banks and the
banking industry reported annualized average returns on assets
of about 0.90 percent.

Most recently, however, some of the

largest institutions have substantially increased their
provisions for loan losses, which will temper the earnings gain
that much of the industry has made.
Much of the earnings improvement last year reflected
sharply lower loan loss provisions by the largest institutions,
but other factors were also important, as well.

Many of the

larger companies, in particular, have increased their emphasis
on generating noninterest revenues and on controlling operating
expenses.

Noninterest income of the 25 largest bank holding

companies, from such sources as investment banking, asset sales,
service charges, and loan commitments, as well as from foreign
exchange and securities trading and other activities, has more
than doubled in the past five years relative to total assets.
That trend may continue as the largest banking organizations
search for ways to improve investor returns while minimizing
their credit risks and their need for additional shareholder
funds.
The relatively low level of loss provisioning
continued through the first-half of 1989, as well.

However, by

the third-quarter, many of the largest companies had announced
substantial additions to their reserves, mostly in anticipation
of further losses among their foreign loans and domestic real

6

estate credits.

The latest provisions give several of the

largest U.S. banking organizations reserves for developing
country loans that exceed 50 percent of their exposure.
The appropriate amount for the reserve depends partly
on the strategy of the lender toward this business.

The

indebted countries clearly need some access to new financing.
Those institutions that take a long-term view and are prepared
to work with the borrowers may well realize higher returns on
their loans than will those who are willing to take near-term
losses and withdraw from that market.

There is no magic number

regarding the appropriate volume of reserves for these loans.
Nevertheless, our policy has been, and remains, to require
additional reserves, when we believe that conditions warrant.
The third-quarter losses that some large companies
have reported, while troubling, should better position the
companies for the future.

Moreover, some companies have coupled

their announcements of special provisions with disclosure of
plans to issue significant amounts of additional common stock.
While efforts to resolve asset quality problems must continue,
actions that increase loan loss reserves and strengthen capital
are welcome.
Asset quality.

Asset quality remains the principal concern

facing the industry.

Some earlier problems seem to have

receded, such as those in the agricultural sector that ravaged
many Midwestern banks, but others remain.

Loans to some highly

indebted countries continue to undermine the near-term earnings
and competitive positions of some of the largest organizations,

7

and the real estate markets have softened in several formerly
buoyant sections of the country.
Real estate markets in New England, parts of the
Southeast, and broad areas of the Southwest show the most
visible signs of weakness.

Problems in the Northeast have

recently led several institutions there to make substantial
provisions for real estate losses.

Most of those expected

losses, in turn, involve development and construction projects,
including condominium projects, in particular.

Recent trends in

commercial vacancy rates, combined with other factors that could
adversely affect that region's economy, could lead to problems
for other banking institutions, as well.
Relative to total assets, the volume of nonperforming
assets for the industry increased during the first half of 1989,
after declining during 1988.

The volume of weak assets remains

stubbornly high for the larger banking organizations, in large
part due to their exposure to foreign borrowers.

Nonperforming

assets of the 25 largest bank holding companies increased
slightly to 3.1 percent of their total assets at mid-year, which
is well above the average 2.2 percent reported by all holding
companies.

I will say more about the foreign debt situation

later.
Exposure to highly leveraged borrowers; including
involvement in leveraged buyouts and other highly leveraged
financings, also has important implications for the risk
profiles of banking institutions.

Such transactions can be

important vehicles for the necessary restructuring of some

8

companies and, in this way, may contribute to the operating
efficiency and financial performance of U.S. businesses.
Nevertheless, the higher debt levels and relatively lower equity
cushions that characterize such transactions can also weaken the
borrower's ability to withstand financial adversity and, other
things being equal, can raise the level of risk in bank loan
portfolios.
At mid-year 1989, the 50 largest bank holding
companies had total loans and commitments to highly leveraged
borrowers of more than $100 billion, a 20 percent increase from
the level they reported at the end of 1988.

Although the vast

majority of these claims are in the form of senior debt, the
amounts outstanding are substantial for many companies, both in
absolute terras and relative to their equity capital.

This is

clearly an area that warrants particularly close attention by
bank managers and supervisors alike.
Capital adequacy.

An important indicator of the strength of

the banking system is the measure of capital adeq: ¿ry.
Accordingly, developing both an accurate measure and

n

appropriate standard for evaluating the capital adequacy of
banking organizations has always been of prime importance. The
international risk-based capital standard adopted during the
past year represents a milestone in international cooperation
and should help to strengthen capital standards throughout the
world.
Although the new standard is not effective until the
end of 1990 and will not be fully implemented until two years

9

later, most banking organizations are focusing on those
requirements now.

We estimate that about 94 percent of the

nation's commercial banks met or exceeded the minimum risk-based
capital standard at mid-year, even under the more-rigorous 1992
definitions.

Even many of the large regional and money center

bank holding companies meet the standard, or are well on their
way toward meeting it.
The actions some companies have taken to raise
additional capital in response to the future risk-based capital
requirements also improve their capital ratios, as measured by
current standards. Primary capital, for example, which includes
equity capital, loan loss reserves, and a few other components,
averaged 8.25 percent of adjusted as.'Dts at mid-year 1989 for
all bank holding companies with assets exceeding $150 million.
That figure compares with 8.08 percent at the and of 1988 and

with 7 .90 percent the year before.

general improveront has

been widespread.
Much of the improvement in recent years has c o •«
through slower asset growth, especn
larger institutions.

. ’ on the part of t c
i?

During 1988, total assets of all insured

ccr°r: ^1 banks grew by only 4.4 percent, compared with rates
of 7 to 8 percent during the first-half of this decade and with

rates in the mid- to low-teens during the 1970s.

Average asset

growth among the 25 largest banks has virtually stopped,
increasing by only 0.6 percent last year after being virtually
unchanged during 1987.

1 0

Some of that slowdown reflects efforts to meet
stronger capital standards, reduce foreign exposure, securitize
assets, and focus on off-balance sheet and other fee-generating
activities.

Growth of outstanding loan commitments and foreign

exchange and interest rate contracts, for example, has been much
stronger than asset growth in recent years.

Transfers of

certain securities activities from banks to bank holding company
affiliates also explains some of the slow growth by these large
banks.

Measured on a consolidated holding company basis, the 25

largest institutions grew by 4.2 percent last year.
The risk-based capital standard imposes specific
minimum ratios for "Tier 1" (largely equity) capital as a
percent of assets.

That emphasis on equity should support and,

hopefully, help to extend the improvement we have seen in
equity-to-asset ratios.

At the end of 1988, for example, bank

holding companies with assets exceeding $150 million reported
equity equal to nearly 6.0 percent of their total assets— more
than a percentage point higher than at the beginning of the
decade.

Although the the 25 largest companies reported a lower

average equity ratio of 5.33 percent, their relative improvement
was even greater during that period.
The thrift industry problems have demonstrated the
need for financial institutions to maintain adequate levels of
tangible capital to absorb unexpected losses.

The Federal

Reserve shall continue to enforce prudent standards for state
member banks and bank holding companies and ensure that these
capital standards remain sound.

The role of intangible assets,

1 1

such as goodwill, in the capital measure for banks is minor now
and will decline further during the next few years as the new
standards are put in place.

We shall also continue our efforts

to coordinate those standards internationally so that they are
administered similarly throughout the world and that U.S.
banking organizations can compete worldwide on a more equitable
basis.
The Committee has asked whether the Federal Reserve
believes that the U.S. banking system currently has sufficient
capital to protect the public interest and avoid a serious drain
of the bank insurance fund.

Many bankers will testify that we

seem constantly to urge higher levels of capital.

Increased

risks resulting from greater competition, expanding powers, and
a rapidly changing environment for banking services suggest that
some institutions should have materially higher levels of
shareholder funds.

In those cases, we have and shall continue

to urge institutions to raise the necessary funds.

Overall,

though, the Committee should recognize the considerable progress
the industry has made to improve its capital position.
In addition to issuing more equity securities, the
domestic banking industry has generated substantial funds
through increased retained earnings.

Over the last several

years, a trend toward higher earnings and lower dividend payout
rates of large banks were especially helpful in that regard.
During the past five years, the retained earnings of all insured
U.S. commercial banks rose by $39 billion, or 79 percent.
comparison, their total assets grew by only 31 percent.

By

1 2

The new risk-based capital standard will identify the
need for capital by relating the requirements to the specific
composition of risk each organization accepts.

The measure,

however, is not a panacea and cannot be put on automatic pilot
and then ignored.

An adequate capital standard is a critical

element of a sound supervisory system, but it is only one of
many components.

Vigilant supervision, thorough examinations,

and prompt enforcement actions are other essential elements that
I will address next.

EXAMINATION EFFORTS

The Federal Reserve believes that frequent on-site examinations
are a critical component of an effective supervisory framework.
In this regard, the Federal Reserve's policy is to examine all
state member banks and bank holding companies with significant
operations on an annual basis, either directly or in conjunction
with state supervisory agencies.

Problem institutions are

examined more frequently, and are subject to other more rigorous
supervisory reviews.
Conditions of the past several years, in both the
banking and thrift industries, have imposed significant
pressures on our field examination resources.

This year, in

particular, our involvement in thrift institution examinations
and closings has forced us to postpone the regular periodic
examinations of some institutions that appear to be healthy and
to limit the examination scope of others.

While we can make

such adjustments temporarily, we cannot do so for extended

13

periods.

Such actions would increase the possibility that

problems could develop and grow without early detection.

In

light of these and other developments I have discussed in this
statement, it is crucial that we continue to devote adequate
resources to on-site examinations and other critical supervisory
functions.

It is also essential that we take any steps

necessary to attract and retain qualified field examiners and
supervisory personnel.

INTERNATIONAL DEBT SITUATION

A significant area of concern for some of the nation's largest
banking organizations continues to be their exposure to
developing countries.

The U.S. banking system is now much less

vulnerable to debt servicing difficulties by these countries
than it was in the early 1980s.
problem is behind us.

That is not to say that the

At mid-year, exposure to problem debtor

countries still represented more than 90 percent of the combined
primary capital of the 9 most internationally active U.S. banks
and almost 40 percent of the capital of 13 others.
Fortunately, though, this vulnerability continues to
decline from much higher levels a few years ago.

During 1988,

alone, those 22 large banks reduced their net exposure to
problem debtor countries by almost $9 billion.

In the first six

months of this year, they reduced it another $4.5 billion.

This

progress has been made by reducing the exposure through a
combination of asset sales, swaps, and charge-offs and, more
importantly, by strengthening the capital and reserve base of

14

the lending institutions.

Indeed, by creating strong levels of

reserves, most regional and super-regional banking organizations
have nearly removed these exposures as a major determinant of
their financial strength.
Several large banks have recently further increased
reserves against developing country debt.

On balance, the Board

views this as a positive development toward strengthening the
banking system.

However, both the banks and the regulatory

agencies must continue to review these reserves on an ongoing
basis to ensure that the level of bank reserves and capital is
appropriate with current circumstances.

Moreover, from the

banks' own perspective as well as from the perspective of the
international economy, commercial banks should continue to work
with the borrowers and the international institutions in a
continuing cooperative effort to improve the economies of these
countries and, thereby, their ability to service their debts.

PROBLEM AND FAILED INSTITUTIONS
During 1988, the number of failed banks had reached another
post-war high of 200 institutions, compared with 184 in 1987.
An additional 21 banks with assets of $13.5 billion were
operating with FDIC assistance while a permanent solution was
being reached.

Since the total failures included numerous

subsidiaries of several of the largest Texas banking
organizations, the assets of the failed banks soared to $40.3
billion in 1988 from $6.9 billion the year before.

15

Both the number and size of bank failures has
continued at high levels this year.

Through September 1989, 160

commercial banks had failed, with total assets of $25.7
billion.

The failures were heavily concentrated in the

Southwest.

Failures in the West and Midwest declined during

1988 from their 1986-1987 peaks and accounted for only 20
failures in the first nine months of this year.

With respect to

the Federal Reserve's specific activities, 9 state member banks
have failed through September, compared with 21 for all of 1988.
The number and assets of problem institutions also
remains historically and unacceptably high, but also appear to
have peaked.

Both figures declined slightly in 1988 and have

dropped further during 1989.

At the end of the third quarter,

1,166 commercial banks were considered problem institutions by
the FDIC, compared with a high of 1,575 banks at the end of
1987.

Most of them are located in the Southwest, while

conditions in the West and Midwest have improved.

Softness in

the automobile industry could aggravate economic conditions in
the Midwest but, barring new major problems, should not reverse
the trends toward fewer problem banks in that area.

SUPERVISORY AND REGULATORY INITIATIVES

The Federal Reserve, often in cooperation with the other federal
bank regulatory agencies, has adopted a number of significant
measures in recent years to address real and potential risks in
banks.

As indicated earlier, we have also provided significant

examination resources to help identify and resolve insolvent

16

thrifts.

Several of the major new initiatives are summarized

below:
Capital standards. Late last year the Board adopted a new
risk-based capital standard for state member banks and bank
holding companies that was based on negotiations conducted
through the Bank for International Settlements.

As I have

suggested, this international standard emphasizes the need for
"core" shareholder funds, recognizes risks in certain
off-balance sheet activities, and varies the amount of capital
required for various types of assets by the amount of perceived
credit risk contained in each asset or exposure.

This standard

should tailor each institution's capital requirements more
closely to its willingness to accept risk and should also lead
to more equitable competition among major banks worldwide.
The Board fully supports strong capital standards and
has worked hard to improve the capitalization of the banking
industry.

Our influence comes not only through supervisory

actions, but also from administering the bank holding company
application process.

When deciding requests of banking

organizations to merge with or acquire other institutions, the
Federal Reserve has and will continue to require applicants to
raise additional shareholder funds, when necessary.

This

process will involve prohibiting poorly capitalized institutions
from expanding through mergers and acquisitions and, at times,
may even require other companies to strengthen their financial
positions further.

In that way, the structural changes

17

occurring within the industry can lead to a stronger banking
system.
Highly leveraged financings (HLFs). Early this year the Board
revised its 1984 examination guidelines on HLFs, including
leveraged buyouts, to strengthen its cautionary language and to
stress further the need for lending institutions to thoroughly
evaluate the financial strength of the borrowers.

The new

statement emphasized the importance of (1) evaluating cash flows
under varying economic conditions, (2) setting reasonable
"in-house" limits on the consolidated exposure of HLF borrowers,
and (3) establishing specific policies, procedures, and controls
for HLF lending.

The statement also urged banks to price these

credits prudently in order to reflect adequately the trade-off
between risk and return and to avoid compromising sound banking
practices in a search for market share and short-term gains.
The Federal Reserve Banks have also employed these
guidelines to give special attention to loans to customers with
exceptionally high debt profiles.

In this connection, the

federal banking agencies have recently developed a definition of
highly leveraged financings that they can use for examination
and supervisory purposes.

Such a consistent definition should

help identify trends and compare the exposures of individual
institutions.
New securities powers.

Earlier this year, the Board agreed to

permit several large U.S. bank holding companies to expand their
securities activities by underwriting, on a limited basis,
corporate debt and equity within the United States.

However,

18

before the companies could conduct those new activities they
were required to demonstrate that they had adequate capital,
managerial expertise, and controls.

The Board granted its

permission immediately for them to underwrite commercial debt
instruments, and by mid-year four companies had done that.
However, the Board has withheld for at least one year its
consent for them to underwrite equities.

By its conditional

approval, however, the Board indicated its willingness to allow
U.S. banking organizations to provide that service, if proper
systems are in place to control the risks.
This decision was made in response to changing market
conditions and competitive positions and on the basis of
existing authority granted in the Bank Holding Company Act.

The

Board was mindful of any increased risks such activities might
present to the organization's core banking business and took
special steps to ensure that the new underwriting powers were
separated from the activities of any subsidiary bank(s) and that
appropriate prudential safeguards were in place to protect
affiliated banks.

It also took special steps to ensure that the

banking organizations conducting these activities were well
capitalized or that they raised additional equity to support
these incremental risks.

That approach should improve the

ability of domestic bank holding companies to compete more
effectively with foreign and nonbank institutions, while
protecting the public's interest in a safe and sound banking
system.

19

Hostile takeovers.

Through past decisions, the Board has

indicated its intent to remain neutral on the issue of friendly
or unfriendly acquisitions of domestic banking organizations.
Its principal interest in all acquisitions continues to be that
the resulting organization be financially sound and have a
strong capital position.

The Federal Reserve will not, however,

allow an institution to weaken its own condition significantly,
either in an attempt to consummate an acquisition or to prevent
one.
Interbank payments system.

An important and on-going objective

of the Federal Reserve has been the implementation of policies
both to reduce Federal Reserve risk in providing payments
services and to induce private participants to be more prudent
in controlling their daylight credit exposures, particularly on
private large-dollar payment systems.

The largest of these,

CHIPS, has agreed to adopt rules making settlement of their
system more certain through both collateral and loss-sharing
devices.

In addition, the Board has adopted guidelines to

reduce credit exposures on other domestic and foreign clearance
and payments systems.
Last spring, the Board also proposed additional
measures to encourage depository institutions to control their
credit exposure by expanding the scope of its payments risk
reduction program.

Among other features, the proposals will

impose explicit prices on Federal Reserve daylight credits and
expand the use of collateral as a risk control technique for
book entry clearance of U.S. government securities.

When fully

2

0

implemented, these changes, together with private sector
initiatives, should reduce the overall level of U.S. payments
system risk, shift the mix of domestic risks toward the private
sector and more accurately assign the risk to the private sector
users of payment services.

CONCLUSION
These past few years have been difficult times for the banking
industry, and significant problems remain.

However, the

performance of most institutions during 1988 and for the first
part of this year, suggests that progress has been made.

The

number of failed institutions seems poised to decline; the
capital ratios for most banking organizations have strengthened;
and the most severe problem institutions have now been
addressed.

We must see further gains, though, before we can say

that the problems that have beleaguered the industry are behind
us.